Collateral

 

Welcome to the first outing of Collateral, MJ Hudson’s quarterly newsletter focusing on the latest restructuring, turnaround and debt matters with insight aimed at institutions at all levels of the capital structure.

Previewing the Year Ahead

In this first newsletter, we discuss some of the recent developments in the restructuring and turnaround world and do some horizon scanning to try and predict which direction European credit might be headed for the remainder of 2019.

Setting the Scene

Despite some prophets of doom and ongoing stock market jitters, 2018 did not signal the beginning of the next recession. Instead, financing continued to be readily available for investors hungry to find high yielding investments and, when things turned sour, the abundant liquidity tended to facilitate covenant resets and extensions in some of the bigger financings. Economic activity still remains relatively strong – mainly driven by benign monetary policies. However, the rumblings of a potentially global economic contraction are getting louder and growing household debt, weakening political stability across a number of EU countries and assorted trade wars could easily derail the current growth story.

Interest Rates

The 2018 rise in UK interest rates generally had little impact on restructurings and the availability of cheap money. However, further interest rate rises are anticipated this year, perhaps signalling the “beginning of the end” for cheap credit and “zombie” companies (companies with high leverage relying on low interest rates and lenders’ patience (fuelled by the hope of a better future)) achieving unexpected refinancings. On the positive side, it is expected that a change in market dynamics may herald a return to valuation-based investing (investing in companies that appear undervalued) with an emphasis on fundamental company analysis.

Cov-Lite 

The rise in covenant lite lending has been much reported on and is a symptom (in part) of low central bank interest rates that have made lenders more willing to lend in riskier situations to enhance returns. As a result most sizeable new finance structures have no meaningful financial triggers until maturity or they run out of cash. The deterioration in covenant protection means the removal of early warning signs for financial distress and allows borrowers to operate longer without breaching covenants but creditors risk not getting a seat at the table as debtors’ financial positions worsen and options diminish.

Unless the trend for loose covenant packages reverses, the market will have to rely on management and financial sponsors to be sensible in identifying situations where they need to engage with their creditors to preserve economic value. We are increasingly seeing such activity with management teams engaging with their core stakeholders pre-emptively in advance of an immediate credit catalyst. And we believe this trend will continue.

Decline of Traditional Retail

The pressures of rising operational costs, digital and online competition and devaluation of sterling will continue to have an impact on consumer habits, in turn affecting traditional retail. Coupled with overexpansion and a high debt burden, we have already seen a number of high profile high street casualties over the past few years: HMV, Toys R Us and Maplin to name a few.

For many in the retail sector, 2018 was the year of the company voluntary arrangement (CVA) as many well-known businesses resorted to this restructuring tool in an effort to escape unprofitable stores or leases. Market reaction to CVAs has been mixed. Many large property companies and investors are unhappy about the way in which rent reductions and store closures are being imposed upon them, while other creditors seem to escape without any financial pain. Commentators also point out that, although CVAs give companies a second chance to return to profit, the ‘’sticking plaster’’ solution tends to fail for the very same reasons that caused retailers to enter insolvency in the first place.

Retailers and financial experts do not paint a healthy picture for the year ahead and we are likely to see an increased number of insolvencies and restructurings in the retail sector in the near term.

Legal reforms

In late August 2018, following the two high profile corporate failures of Carillion and BHS, the UK government issued a statement announcing major changes to the corporate insolvency framework. The reforms will include the introduction of a restructuring moratorium to help business rescue and the creation of a new restructuring plan (modelled broadly on the current Scheme of Arrangement).

Linked to these reforms, the government has also announced that that directors of holding companies will be legally obliged to take into account whether the sale of a large subsidiary is in the best interests of the subsidiary’s stakeholders – as opposed to placing the subsidiary into formal insolvency proceedings. Sanctions for non-compliance will include disqualification for directors.

They key question – which remains unanswered – is how directors of holding companies will balance the existing duty to act in the best interests of that company with the new duty to also act in the interests of the subsidiary’s stakeholders? In light of these proposed reforms it remains to be seen whether being a director in times of distress becomes even more complicated to navigate….

Brexit… The Saga Continues 

Finally, as the UK prepares to withdraw from the EU in March 2019, this newsletter cannot avoid a mention of Brexit. It is of course impossible to predict the impact of the final Brexit outcome but in the restructuring context, it seems highly unlikely that Brexit will spell the end of the EU cross-border legislation relevant to restructuring and insolvency in the UK. It is more likely that such legislation will remain in force. What is far from certain once the UK is no longer part of the EU is how the remaining member states will choose to treat the proceedings and decisions taking place and made in English courts.

‘’No deal’’ will mean that the Insolvency (Amendment) (EU Exit) Regulations come into force, effectively transplanting the Recast Brussels Regulation1 with effect from 29 March 2019 and making a number of amendments to domestic legislation from that date. Alternatively, if the UK exits the EU with a deal, we can expect further negotiations to determine the extent to which the UK retains any of the benefits and obligations under the European Insolvency Regulation2 and the Recast Brussels Regulation during any transition period.

It is the government’s stated policy to seek a post-Brexit agreement which closely reflects the existing framework of mutual recognition and cooperation on civil judicial matters, including, specifically, insolvency. While this is positive, it takes twenty-eight to make a bargain of this kind, and the shape of the future judicial relationship remains uncertain….So stay tuned!

1 The Recast Brussels Regulation allows for court judgments made in one EU country to be automatically recognised – and therefore enforceable – in other parts of the EU.
2 The European Insolvency Regulation ensures that the appointment of an administrator, liquidator, or trustee in bankruptcy in one EU member state is automatically recognised in other EU jurisdictions.